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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the 2007 Managed Account Solutions Conference


Andrew J. Donohue1

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Money Management Institute
New York, New York
October 19, 2007


Thank you very much for inviting me here this morning. I would like to specifically thank conference co-chairs Jim Tracy and my former colleague Donna Winn for inviting me to speak to you. In addition, I would like to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the SEC staff.

At the outset of my remarks I want to congratulate the organizers of this conference for coming up with a compelling name for the event — Managed Account Solutions. Throughout my 30-year career in the asset management industry, I felt as though I came away from every conference with far more problems than solutions. Inevitably, I would learn about a new regulatory issue or an emerging industry trend that would have significant implications for my organization. Instead of heading back to the office with solutions in hand, I always seemed to be walking in with more to worry about.

At least, as a result of attending the conference, my worries were better informed. In fact, in my opinion, it is always better to know what issues you face than to pretend that new regulatory developments and industry innovations are not on the horizon — or that they won't affect you.

So, with that in mind, I plan to review with you some of the regulatory issues the Commission and my staff in the Division of Investment Management are addressing that have relevance for separately managed accounts.

I often hear reference to a trend of increasing regulatory focus on SMA programs. Given the significant growth in SMAs and other managed account options in recent years, I believe this regulatory focus is well placed. In addition, SMAs are a product traditionally designed to meet the needs of individual investors, rather than large, sophisticated institutional investors. As a result, additional review and monitoring by regulators seems warranted and appropriate.

Furthermore, a significant portion of the investment adviser registrant population is involved, in some capacity, with wrap fee programs or SMAs. Based on IARD data from the Commission's investment adviser registrant database, as of September 30, 2007 there were 10,817 investment advisers registered with the Commission. Of these, 486 advisers (4.5%) indicated that they sponsor a wrap fee program and 1,110 advisers (over 10%) indicated that they act as a portfolio manager for a wrap fee program. Thus, wrap fee programs or SMAs are a segment of the market that certainly cannot be ignored by those with regulatory responsibilities.

Response to the FPA Decision — Principal Trade Relief and Potential Impact on SMA Accounts

I would now like to turn to a recent Commission action that has been closely watched by the investment adviser, broker-dealer and investor communities. And that is the principal trading rulemaking that responds to the decision by the Court of Appeals for the DC Circuit in Financial Planning Association v. SEC. While the rulemaking initiative was fashioned in response to the FPA decision, I understand that many types of investment advisers, including those that manage SMA assets, are interested in the rule and whether it may at some point be expanded to other types of advisers or advisory accounts.


As you are probably aware, the FPA decision vacated the Commission's rule that provided that fee-based brokerage accounts were not advisory accounts and thus were not subject to the Investment Advisers Act. The court's decision took effect on October 1st, which means that the Advisers Act now applies to broker-dealers offering those accounts.

As my staff began discussing the effect of the FPA decision with interested parties, two things became clear. First, for operational reasons, many broker-dealers (though not all) structured their fee-based brokerage accounts in a way that did not allow them simply to apply the Advisers Act to those accounts. For this reason, many firms asked their fee-based brokerage customers to convert their accounts either to advisory accounts or to traditional commission-based brokerage accounts. Before the FPA decision, there were about one million fee-based brokerage accounts, holding about 300 billion dollars, so this conversion process represented a large undertaking.

Second, broker-dealers argued that the requirements of section 206(3) of the Advisers Act make it impractical for the firms to offer their advisory clients transactions in certain securities which frequently trade on a principal basis. These securities include many kinds of debt obligations, including municipal bonds. Broker-dealers represented to us that many of the fee-based brokerage customers, as a practical matter, would be unable or unwilling to transition to an advisory account, and thus would be unable to maintain a fee-based account with the additional protections of the Advisers Act.

Section 206(3) prohibits an investment adviser from knowingly engaging in a transaction with its client for its own account — that is trading as principal — without disclosing in writing to the client the capacity in which it is acting, and obtaining the consent of the client.

New Rule 206(3)-3T

In an effort to allow fee-based brokerage customers who convert to advisory accounts to continue to have access to a firm's inventory of securities, the Commission adopted, on a temporary basis, a new rule that establishes an alternative means for a firm to comply with Section 206(3). New rule 206(3)-3T permits an adviser that also is a registered broker-dealer to give oral disclosure prior to each principal trade rather than the written disclosure otherwise required by section 206(3). The rule applies only to non-discretionary accounts — where there already is client involvement in every transaction.

It has a number of other conditions designed to prevent overreaching by advisers, including that the adviser make prospective disclosure to the client in writing of the conflicts arising from principal trades. The rule also requires that the investment adviser be registered as a broker-dealer and that, in addition to the protections of the Advisers Act, the protections of the Securities Exchange Act and the conduct rules of relevant self-regulatory organizations apply to each account for which the adviser relies on this rule.

The rule contains a sunset provision. Absent further action by the Commission, the temporary rule will expire on December 31, 2009. This gives the Commission and the staff an opportunity to observe how firms comply with their disclosure obligations under the rule, and whether, when they conduct principal trades with their clients, they serve their clients' best interests.

Comment Period and Potential Impact on SMA Accounts

The Commission has requested comment on all aspects of the temporary rule, with the comment period closing on November 30, 2007. At my last check, the Commission had not yet received any comments on the temporary rule.

However, I have seen a press report indicating that some investment advisers may have an interest in recommending that the relief be expanded to include advisers with affiliated broker-dealers, in addition to those that are dual registrants. In addition, the press report indicated that some advisers may have an interest in recommending that the relief be expanded to include discretionary advisory accounts, such as SMA accounts. I assure you that I will seriously consider these and related issues that may be raised during the comment process as we evaluate the rule and make recommendations to the Commission going forward.

IA/BD Study and the Implications for SMAs

Related to the FPA decision and the issue of the roles that investment advisers and broker dealers play in the retail marketplace is the study of the broker-dealer and advisory industries that the RAND Corporation is conducting. Following the FPA decision, Chairman Cox approved additional emergency funding to accelerate this study so that it will be delivered to the Commission no later than December of this year, which is several months ahead of schedule. I expect the resulting study to provide us with useful data about the ways in which broker-dealers and investment advisers market, sell, and deliver financial products, accounts, programs, and services to individual investors. Certainly SMAs, UMAs and other managed accounts will be relevant to that analysis. I also expect that data in the study will provide additional insight on the perceptions and understanding of investors as they consider the myriad of financial products, accounts, programs and services that are available to them through various financial professionals.

The study also should help the Commission to more fully evaluate how it can improve investor protection by updating its regulations to deal with the realities of today's marketplace. I look forward to reviewing and analyzing the data developed as part of the RAND study. I am hopeful that the study will provide meaningful input as we in the Division of Investment Management and our colleagues in the Division of Market Regulation consider possible recommendations to the Commission regarding the appropriate regulatory landscape for those providing financial services to retail investors.

ADV, Part 2

I would now like to turn to one of the most important investment adviser initiatives that my staff is working on — and that is a recommendation that the Commission re-propose Part 2 of Form ADV. While you may not be aware of it, the wrap account industry has played a leading role in this initiative.

Form ADV, Part 2 is the primary disclosure document that investment advisers provide to clients and prospective clients. It contains information about the adviser's business, backgrounds of advisory personnel, disciplinary information and conflicts of interest. In terms of client communication, the importance of Form ADV cannot be overstated.

The Commission's substantial amendments to Part 1 of Form ADV in 2000, along with the institution of the IARD electronic registration system and the establishment of the Investment Adviser Public Disclosure website, were the first steps in revolutionizing, not only the content of advisers' disclosures, but also the process by which investors, regulators and the general public could access information about investment advisers. We have seen major benefits from these developments in terms of enhanced disclosure and transparency and ease of access to information. The web-based system has greatly assisted the public's ability to access information about investment advisers. An investor or member of the public can locate current information about an investment adviser through just a few clicks on the SEC's website.

The Commission delayed adopting the amendments to Part 2 in 2000 to enable the Commission and investment advisers to focus on preparing a new Part 1 of Form ADV and transitioning to electronic filing — and to allow the Commission time to fully consider the many comments it received on the proposed Part 2 revisions.

Since 2000, however, there have been significant changes in the investment advisory industry, including the introduction of new types of managed accounts. There also have been significant regulatory changes, including the adoption of rules mandating that investment advisers have chief compliance officers, written compliance policies and procedures, and codes of ethics. In light of the changed business and regulatory landscape, we plan to recommend that the Commission re-propose Part 2 so that we can obtain a fresh set of comments on this initiative before we recommend that the Commission consider adoption.

In the original Part 2 proposal issued in 2000, the Commission proposed changing Part 2 from a check-the-box format with continuation sheets to a free-form text, plain English, narrative document. This proposed change in format was well-received by both industry representatives and investors.

In fact, in many ways, the SMA or wrap account industry was at the forefront of this momentous change in investment adviser disclosure and client communication. The concept behind the Part 2 disclosure revisions is based on the current Schedule H to Form ADV. The admittedly bureaucratic name refers to the specialized disclosure document that is provided to wrap fee clients. The Commission first required this specialized form in 1994. The specialized wrap fee program narrative document has generally worked well in providing a medium in which important information about the operation and attendant conflicts of wrap fee programs can be described to wrap account investors. I am hopeful that we can incorporate this positive experience into the revised Form ADV, Part 2 that will be applicable to the broader registered investment adviser universe.

Trade Execution and SMAs

I would now like to turn to the important issue of trade execution and the specialized challenges that may impact execution of trades in SMA accounts. As you are aware, brokerage commissions (and spreads and markups) are an asset of the client — and not an asset of the adviser executing trades on behalf of a client. Furthermore, as I have said before, seeking to achieve best execution should not be limited to equity trades. There are best execution challenges in other asset classes as well, including fixed income. In addition, best execution inquiries should be made across all accounts and products, each of which, including SMAs, may have its own best execution issues and challenges.

If asset management clients are in arrangements, such as SMAs, in which the placement of trades may be based on or influenced by factors other than an attempt to achieve best execution, the client should be fully informed of, and consent to, this arrangement. Thus, the client should be told that trades will be placed with an SMA's sponsor, why the trades are placed with the SMA's sponsor and the impact that placement may have on execution of trades. Furthermore, the client should consent to the arrangement.

There can, of course, be very legitimate reasons for an asset manager to place an SMA client's trades with the SMA's sponsor. The client is paying a single fee for both asset management and trade execution services. Thus, if the asset manager places a trade with a broker-dealer other than the SMA sponsor, the SMA client incurs a separate charge — possibly a charge the client was not expecting.

At the same time, however, there is the possibility that a non-SMA sponsor broker-dealer may be in a position to provide better execution in a particular circumstance — all things considered. SMA market participants should consider the extent to which this situation exists and the extent to which clients are informed of the way that trade placement decisions are made in the SMA context.

Review of Rules Relevant to SMAs

Before ending my regulatory overview, I want to discuss one of the functions that I believe is critical for a regulator: reviewing relevant rules to ensure that they continue to be effective and workable. As many of you are aware, wrap fee programs and SMAs operate outside the jurisdiction of the Investment Company Act pursuant to rule 3a-4, which provides a safe harbor from the definition of investment company for programs that provide discretionary investment advisory services to clients.

The Commission adopted this rule in 1997, and it has been unchanged since then. However, as with all of the rules under the Investment Company and Investment Advisers Act that my Division administers, I believe regulators should not adopt a rule and then move on to the next project without ever looking back.

As responsible regulators, I believe Division staff should continuously reassess the rules that are on the books. We should consider whether investment management rules, once they have been implemented, address the regulatory goals identified by the Commission when adopting them — and whether the regulatory goals are met in a cost-effective manner. Further, we should evaluate whether current rules create unexpected operational challenges or require updating because of, for example, enhanced technologies or investor protection concerns.

It is with this framework in mind, that I believe that the rules administered by my Division, including rule 3a-4, should be considered. If you believe rule 3a-4 as written, as interpreted or as implemented should be modified, I would be very interested in hearing your views. Furthermore, I believe it is important that we periodically review the conditions in rule 3a-4 to consider whether they provide for an appropriate level of individualized treatment to support an exception from the definition of investment company for certain types of managed accounts or investment advisory programs.

As the managed accounts industry continues to evolve, it is essential that industry representatives and regulators consider the regulatory consequences. In some cases, changes in the nature of client accounts and services can raise significant threshold issues, such as Who is an adviser? Who is executing trades? Is a vehicle or collection of like accounts an investment company? Is a service provider an investment adviser, a broker-dealer, neither or both?

These are important issues that cannot be ignored, though I have seen them be looked over in the rush to provide a new type of client account or get a new product to market. I encourage you to stop and consider these important threshold questions before moving forward with innovations. I also encourage you to reach out to my staff if you are uncertain about the status of a service provider or the regulatory treatment of a particular account or transaction.


In conclusion, there is no doubt that evolution continues to occur in the managed account space. The emergence of unified managed accounts or UMAs as well as more traditional SMAs and wrap accounts has provided investors with additional choices and additional pricing options.

Additional choice generally benefits investors, and I support product innovation that is motivated by a genuine desire to serve investors' needs. However, as innovations occur and new products are developed, it is critical that managed account executives consider the compliance implications of that innovation and product development. If questions or uncertainties arise, we on the staff are interested in hearing about them. Similarly, if the Commission's regulations become outdated or ineffective as the industry grows and develops, I support reconsideration of the regulations in order to make them meaningful in the 21st century.

Thank you very much and once again thank you for the opportunity to appear before you today. I hope you enjoy the remainder of the conference.



Modified: 10/19/2007